Most professionally managed portfolios follow a customized asset allocation strategy—a defined mix of stocks, bonds and cash (or funds that invest in these securities) that reflects the investor’s specific investment objective, including their timeframe and risk tolerance.
Different portfolios may employ different asset mixes. For example, if you’re 30 years old, you may invest 70% or more of your retirement portfolio in stocks and 30% in bonds. If you have a separate short-term portfolio reserved for the down payment on a house, you might invest 80% or more in cash and more conservative bond investments.
While these target weightings of asset classes gradually shift over time, on a year-over-year basis they’re meant to remain consistent--unless your investment objective changes. To maintain these asset weightings, rebalancing is often required. It is an important investment management service offered by financial advisors.
What is rebalancing?
Rebalancing corrects “drifts” in a portfolio by restoring its mix of stocks, bonds and cash to their original target weightings. While a library’s worth of research studies has debated the optimal frequency of rebalancing, most financial advisors rebalance their clients’ portfolios on either an annual, quarterly or monthly basis.
There are, however, situations where rebalancing may occur more often. For example, if market events result in the value of stocks or bonds greatly exceeding their target weightings, an advisor might rebalance to realign the portfolio.
Let’s use a hypothetical example to illustrate this process.
A market-driven action plan
Let’s say that on January 1 your financial advisor invests your $500,000 Rollover IRA in an asset mix of 60% stocks and 40% bonds. The advisor normally rebalances the account once a year unless its target weightings increase or decrease by more than 5%.
At the end of June, a six-month stock market rally has increased the value of your stocks from $300,000 to $380,000, while a downturn in the bond market has reduced the value of your bond investments from $200,000 to $195,000.
While the stock returns are certainly worth celebrating, your original asset mix is out of whack. Your stocks now account for 66% of the portfolio ($380,000 ÷ $575,000), and your bond weighting has shrunk to 34% ($195,000 ÷ $575,000).
In a situation like this, the advisor would conduct an event-driven rebalancing.
To restore the original asset mix, the advisor would sell securities in the overweighted asset class to buy more in the underweighted class. Using the example above, the advisor would liquidate $35,000 worth of stocks to “rightsize” to a 60% value of $345,000 and use the proceeds to buy $35,000 more in bonds to restore its updated 40% value of $230,000.
Not only do these actions realign the portfolio, but they also let you take advantage of the age-old “buy low/sell high” philosophy. In this case, you’re capturing profits from the sale of appreciated stocks and buying more bonds at a discount.
One by-product of rebalancing in a non-retirement portfolio or trust is that it can generate taxable income, particularly if you’re selling highly appreciated stocks to restore the original stock weightings.
The advantage of using a financial advisor to manage rebalancing is that they will work to minimize negative tax consequences without jeopardizing future returns. They may focus on selling profitable stocks that generate long-term capital gains, which are taxed at a lower rate than short-term capital gains. They may also try to offset net gains by selling moribund stocks that have lost value.
A disciplined approach
Rebalancing instills discipline into your investment plan—and removes emotions that can lead to ill-advised trading decisions made under volatile market conditions. It is a long-term strategy grounded in the conviction that, over time, a consistent investment mix will give you a better chance of achieving your specific objectives.
You don’t always need a financial advisor to execute investment and rebalancing decisions. For example, many 401(k) plans offer online retirement planning tools that can automatically invest your contributions and balances in a defined asset mix and rebalance it when required.
But for portfolios where you need help building and maintaining an investment mix that reflects your investment objectives and in situations where minimizing investment taxes is a major concern, you may be better off letting a qualified, objective financial advisor, often working in tandem with your accountant or tax preparer, handle these responsibilities on your behalf.
This article was authored by Chris Gullotti, a financial advisor located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or [email protected]
This article has been provided for general informational purposes only and should not be interpreted as personalized financial advice. We recommend that you consult with a financial advisor or financial planner before you implement any major changes to your financial plan or investment accounts. Certain sections of this article contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.
©2019 Canby Financial Advisors